Detroit Sewer Sale Sullied as City’s Stress Spreads: Muni Credit

Detroit is reeling from a decades-long decline that pushed down the city's population by 25 percent since 2000. The city’s independently run water and sewer department is preparing to sell $600 million of bonds. Photographer: Jeff Kowalsky/Bloomberg

June 19 (Bloomberg) -- Detroit’s brush with insolvency may
elevate borrowing costs for the city’s independently run Water
and Sewerage Department when it sells $600 million of bonds, the
agency’s biggest offering in nine years.

The sale, which may be as soon as tomorrow, was delayed as
a legal fight surrounding Michigan’s oversight of Detroit’s
finances threatened last week to push the city toward a default
on other bonds. Moody’s Investors Service on June 14 cut the
department’s debt to two ranks above junk status.

The fallout shows how the struggles of cash-strapped
municipalities such as Detroit, Alabama’s Jefferson County and
Harrisburg, Pennsylvania, can reach beyond their borders. About
three-quarters of the sewer department’s customers live outside
Detroit, and the agency’s finances are kept separate from a city
so strapped for cash that it’s getting rid of nearly half its
streetlights.

“Because of the city’s potential bankruptcy and the fact
that it’s a department of the city, that’s always in the back of
your mind and gives you pause,” said Richard Larkin, director
of credit analysis for Herbert J. Sims & Co. in Iselin, New
Jersey. “You may want to get a little extra yield to calm your
nerves.”

Detroit is reeling from a decades-long decline that since
2000 has depressed its population by 25 percent. In April, it
narrowly averted state takeover because of its budget deficit
and $12 billion long-term debt. The city is now under watch of a
nine-member advisory board as part of an agreement with the
state to prevent it from seeking bankruptcy.

Paying Up

The sewage system, overseen by a board appointed by
Detroit’s mayor and officials from suburban counties, serves 2.8
million people, about 30 percent of Michigan’s population, which
buffers it from the city’s shrinkage. Still, when Michigan took
oversight of the city, the utility also was affected.

The move allowed banks, including UBS AG and JPMorgan Chase
& Co., to break off interest-rate swaps, a type of derivative
contract. The agency will use about $300 million from the bond
sale to pay off the swaps.

Matthew Schenk, the water department’s chief operating
officer, said the agency’s funds have always been kept distinct
from the city and it has never risked default. The department
can raise rates on suburban customers without needing the
approval of the Detroit City Council, bond documents say.

“Investors are going to see through the headline risk and
recognize that there’s inherent value to this transaction,”
Schenk said. The sale is its biggest since 2003, according to
data compiled by Bloomberg.

Falling Together

Last week, after Detroit’s brush with insolvency, Moody’s
Investors Service and Fitch Ratings lowered the city’s rating
deeper into noninvestment grade status. Moody’s also lowered
water and sewer debt, saying it’s reviewing how bonds would be
affected if the city goes bankrupt.

A Detroit Water and Sewerage Department bond maturing in
2031, backed by customer bills and with the same rating as the
debt being sold this week, traded for an average yield of 5.19
percent between dealers on June 15. That was up from 4.44
percent when it was last traded in February. The debt is rated
Baa2, Moody’s second-lowest investment grade, the same as the
new issue.

The yield on top-rated securities with a similar maturity
declined about 0.05 percentage point over the same period to
2.82 percent, Bloomberg data show. The interest rate on BBB
bonds dropped 0.06 percentage point to 4.54 percent, the data
show.

Points Magnified

Detroit’s debt “is going to trade at a discount relative
to other water and sewer bonds in the market just because it has
Detroit in the headline,” said Michael Camarella, senior
portfolio manager at OppenheimerFunds Inc., which oversees about
$33 billion in municipal bonds.

The deal may draw demand from buyers seeking higher returns
as yields hold near four-decade lows, said Bart Mosley, the co-president of Trident Municipal Research in New York, a bond
analysis firm.

“People are frustrated with earning less than 2 percent on
their money, and so every extra basis point of spread looms that
much larger,” he said.

Revenue bonds aren’t always immune from municipalities’
fiscal struggles. Jefferson County filed for bankruptcy
protection last year in part to escape from debt secured by
sewer bills, which politicians said couldn’t be raised to cover
the debt without punishing the poor. This month, Scranton,
Pennsylvania, reneged on a pledge to back revenue debt sold by
its parking authority, causing it to default before officials
reversed their decision.

Muddied Issue

The Detroit department’s offering documents for investors
say that the bonds should retain their claim on sewer funds in
any bankruptcy. Still, it said no Michigan city has ever sought
that protection, so the legal issue is not “free from doubt.”

Following are pending sales:

GEORGIA plans to sell about $742 million in general-obligation bonds via competitive sale as soon as June 21,
according to an offering document. The proceeds will be used to
fund capital projects and refund previously issued debt. Moody’s
Investors Service rates the state Aaa, its top grade. (Added
June 19)

WASHINGTON HEALTH CARE FACILITIES AUTHORITY plans to issue
$525 million in revenue bonds as soon as this week, according to
an offering statement. Moody’s rates the debt Aa2, third-highest. Bank of America Merrill Lynch is the underwriter.
(Added June 19)